2018 Quarterly Summaries

Review of Securities Markets, First Quarter, 2018

Portfolios registered moderate declines in the first quarter as the U.S. stock market’s streak of monthly gains ended in February. The broad U.S. and foreign stock indices declined by about 1% for the quarter and U.S. bonds were down by a similar amount.

U.S. stocks entered the year with positive momentum following last year’s strong gains. Investor optimism was further buoyed by the expected boost to corporate earnings and economic growth from the tax cuts passed in December. The positive mood did not last, however. Following large stock market gains in January, investors turned their attention to one potentially pernicious effect of stronger economic growth – rising inflation. In the ensuing selloff, U.S. stocks declined about 10% from their high before recovering somewhat. U.S. stocks came under additional pressure in March as the Trump Administration imposed tariffs on steel and aluminum imports and threatened further tariffs on a wider range of Chinese goods.

The broad U.S. stock market, as measured by the S&P 500 Index, was down 0.8% for the quarter. Small company stocks, as measured by the Russell 2000 Index, performed a bit better, down just 0.1%. Stocks of smaller companies were less adversely impacted by the threat of a trade war since they typically generate a greater portion of their sales and earnings in the U.S. in comparison to larger companies.

Growth stocks outperformed value stocks during the quarter as technology stocks (one of the core growth stock sectors) were the strongest-performing sector, up 3.5%. The valuation differential between growth and value stocks, which was already wide by historical standards at the beginning of the year, ended the quarter even wider. Technology stocks weakened towards the end of the quarter as large tech companies came under criticism from government officials and others for their business practices, heightening the risk that these companies’ future profits will be crimped by increased government regulation.

Stock markets in Europe and Japan also took a breather in the first quarter after strong returns in 2017. The EAFE index, one of the major benchmarks for developed market stocks overseas, declined 1.5%. In contrast, emerging markets were one of the few major asset class categories that generated positive returns during the quarter, up 1.4%.

Rising interest rates weighed on both stock and bond prices during the first quarter as yields on U.S. Treasury bonds rose by 0.25% to 0.50% across the maturity spectrum. While inflation readings remained quite low, investor expectations of future inflation increased. In March, the Federal Reserve followed through with their plan to raise short-term interest rates by 0.25% to a range of 1.5% – 1.75% and reiterated their plan for two more quarter-point rate increases later this year.

Political Turmoil

In some of our recent conversations, we’ve heard a prediction that stocks will experience substantial declines this fall amid expectations of greater political turmoil. As the narrative goes, investors will sell stocks as it becomes increasingly apparent that the Democrats will retake the House in November’s mid-term elections and proceed with impeachment proceedings against President Trump.

This prediction seems plausible so it is appropriate to consider whether investors should reduce their equity allocations in anticipation. We recommend maintaining your current portfolio strategy rather than attempting to time the market based on this prediction. For one, the political landscape is affected by many twists and turns that could lead to a different outcome than predicted. Moreover, since stock prices are affected by many factors, the actual market performance could be very different. As we know from studying market history, investors who attempt to time the market usually fail.

To illustrate the difficulty of successfully timing the market in this instance, imagine you knew with certainty that the Democrats would retake the House and would move to impeach the president shortly thereafter. Even with this knowledge, you would still have to accurately predict the stock market’s reaction to this outcome. We witnessed the difficulty of this exercise when President Trump was elected. Many forecasters predicted big market declines if Trump were to win; instead stocks rallied following the election.

For some perspective on stock market returns during periods of political strife, we examined market performance during the two instances in modern times when the president was under direct threat of being removed from office via impeachment – the proceedings against Presidents Nixon and Clinton.

Starting with Nixon, the House formally initiated an inquiry to consider impeachment in early February of 1974. By late July of that year, the House Judiciary Committee approved three articles of impeachment to be voted upon by the full House. Before the House had a chance to vote, President Nixon resigned on August 8th as he realized he was on the verge of being impeached, convicted, and removed from office. Over the six-month period from the initiation of impeachment proceedings to Nixon’s resignation, the S&P 500 declined 12.3%.

In Clinton’s case, the House formally authorized impeachment investigations in early October of 1998 and then voted to impeach the president on December 19th of that year. The trial in the Senate lasted about a month in early 1999 and President Clinton was acquitted on February 12, 1999. Over the five-month period beginning in October and ending with the acquittal on February 12th, the S&P 500 gained 26.7%.

There is no obvious conclusion based on these two observations – in one instance, stocks declined and in the other, stocks rallied. Differences between the specifics of each president’s case may explain the substantial performance difference. However, perhaps an even greater explanatory factor was the economic backdrop while these inquiries were underway. In 1974, the U.S. was mired in a fairly deep recession precipitated by the first Arab oil embargo whereas, in 1998 and early 1999, the U.S. was enjoying a sustained period of strong economic growth.

Our takeaway from reviewing these two recent periods of political turmoil is that the stock market’s performance was most likely affected more by the health of the economy than politics. Said differently, politics were important only to the extent they affected the economy. It is through this lens we are inclined to consider future developments within the political arena. In today’s market, trade policy is a good example of a place where politics and the economy intersect, and we are following developments in this area closely.

Key Economic Indicators

The latest U.S. GDP figures (fourth quarter 2017) showed the economy growing at an annual rate of 2.9%, which was slightly higher than the consensus estimate. Consumer spending rose a strong 4.0%, partially due to higher auto sales in regions affected by the hurricanes last year.

The latest U.S. employment report showed slowing, but still positive, job growth. Nonfarm payrolls increased by 103,000 in March which was the smallest gain in six months. The unemployment rate was unchanged at 4.1%. Wages grew 2.7% over the prior twelve months which was in line with expectations.

The U.S. Federal Reserve raised the Fed Funds rate by 0.25% at their March meeting to a target range of 1.50% – 1.75%. The Fed also maintained their forecast for two more rate rises in 2018, although an increasing number of Fed officials are forecasting that a third rise may be necessary.

The Bloomberg Commodity Index declined 0.40% during the first quarter. The price of oil increased 7.5% to $64.94 per barrel. Gold rose 1.7% to $1,325 an ounce and the price of silver dropped 3.4% to $16.37 per ounce.

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